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The Euro-Area's First Crisis—A Perfect Storm

Martin Schulz
Research Fellow

January 7, 2009 (Wednesday)

Europe's "real" economy has experienced a strong shock from the financial crisis even before the crisis started to seriously affect production and demand in the U.S. The UK, for example, finds itself in the "worst crisis since WWII" and saw its currency (the British Pound) slump in an unprecedented way. The German economy, Europe's largest, faces negative economic growth beyond -3% for 2009, which would mark the strongest recession in decades as well.

These enormous shocks cannot be explained by the burst of the U.S. ("subprime") real estate bubble and the following global banking crisis alone. Rather, Europe's severe crisis is the result of three interplaying negative developments that culminated in a perfect storm. First, global imbalances in production and consumption trends (especially between the U.S. and Asia) led to a hike in oil and material prices that had a strong negative impact on demand in Europe already in early 2008. Additionally, the strong appreciation of the Euro that followed growing doubts about the long-term stability of the U.S. current account hurt Europe's export industries. Second, the global financial crisis hit the heart of Europe's international banks after the "Lehman Shock" in September 2008 because Europe's "universal" banks have been strongly focusing on investment banking for their profits. Third, Europe saw the development of its own regional imbalances and local bubbles with strong domestic demand and real estate bubbles in the UK, Spain, and parts of Benelux and France. Germany, on the other hand, enjoyed a strong export economy that could only last as long the others were dancing.

The impact of global imbalances on the EU economy
Signs of an economic slowdown had already emerged in early 2008. A dollar flood, growing U.S. consumption, and a boom in Asian production had resulted in exploding oil and raw material prices. Europe gained from this strong demand, but also felt the dark side of the unbalanced global economy when inflation expectations shot up. Gasoline prices, for example, increased beyond 1.50 Euro per liter (almost 270 Yen) in Germany, Europe's industrial powerhouse. The European Central Bank therefore indicated that it would fight inflation and started to hike interest rates. As a result, the Euro appreciated to almost 1.60 to the Dollar and 170 to the Yen. European corporations were therefore faced with increasing costs for inputs and credit while domestic demand deteriorated fast.

Figure 1 Inflation, Production and Consumer Demand

Figure 1 Inflation, Production and Consumer Demand

Source: CEIC Database.
Note: Year on Year changes for the Euro Area. Production and Producer Prices exclude Construction.

At the time, most of these (negative) developments seemed to affect the EU economy in the long run and therefore had a strong impact on the consumption and investment environment. Lax policies and over-consumption in the U.S. seemed to have put the Dollar on a path of long-term depreciation towards the Euro. The development of China and India seemed to hike energy and material prices to new heights. European consumers reacted as during the oil crisis of the 80s and stopped buying even before industrial production, investment or exports had slowed. This prepared the negative breeding ground for a crisis that hit when the financial crisis in the U.S. triggered a global recession.

The global financial crisis and the role of European banks
Europe's major banks had profited from a decade of extraordinary financial and exchange rate stability. Internationally they had participated in financial innovation and deregulation that was driven by U.S. investment banks and hedge funds. As "universal" banks, they were free to grow their investment banking units as a main source of profits in all major markets globally. Regionally, they gained from European integration and deregulation that allowed the banks to build Europe-wide operations across borders. So banks were able to collect deposits in high savings, low interest rate member states such as Germany and invest in high return markets with regional booms such as Iceland, Ireland, or financial derivatives in the U.S.

When financial crisis struck, European banks were therefore hit from three directions. 1) Most of their profits came from investment banking with high leverage and high risks. 2) Necessary bailouts seemed to be difficult to implement in the EU because there was no integrated financial regulator (such as the Japanese FSA) and no central government that could provide the necessary funds in a timely manner. 3) While being tightly regulated in their domestic markets, national regulators were often oblivious of the risks banks had built up across the borders or in international financial markets. Especially the boards of public banks (under control of local politicians) often had little knowledge about their banks off-balance-sheet operations.

Imbalances within the EU economy
Another important source of instability were imbalances within the European economy. Real estate bubbles were driven by a financial intermediation boom in the UK, a FDI boom in Ireland and a construction boom in Spain. European banks exploited these developments but also became victims when the later bubbles burst. Even the EU’s major economy Germany, while not enjoying a bubble of its own, became an important part in the development of EU-wide imbalances because its recovery was mostly based on its oversized export industry and not on healthy domestic demand. These imbalances will further bug the EU economy after the financial crisis has been solved. Especially governmental fiscal policies as a reaction to the crisis are on the way to further cementing regional imbalances instead of solving them. National governments could not agree on a coordinated fiscal and strategic response, such as increasing demand in Germany and deleveraging financial sectors in the UK. Instead, they started to implement national fiscal rescue packages that support their troubled (and trouble causing) national sectors instead.

The UK, for example, ran into the crisis with strong current account deficits because of a consumption and construction boom. Fiscal policy now increases the deficit for 2009 beyond 8% of GDP, to push consumption with a sales tax reduction from 17.5 to 15% and support construction and infrastructure investment. France, which suffered from overregulation and an overly strong public sector, is preparing support for “national champion” industries of government-related companies (especially cars and construction). Italy, with its generous and troubled pension and social security programs is planning to distribute payments to pensioners and low income families. Spain, with its burst real estate bubble, is putting more public money into construction investment. Germany, on the other hand, only very reluctantly accepted any need for support of domestic demand, and initially only considered the support of its struggling export industries with tax cuts and credit guarantees. In sum, all of these measures focus on supporting the regional specifics of the various economies for short-term relief instead of looking for long-term solutions to imbalances and causes of the crisis.

Outlook for growth
The impact of the financial crisis in Europe was severe and early, and the impact on the real economy is still unfolding. But it is also noteworthy that the ECB and national governments had acted timely and in a coordinated way to bail out their banking sectors. As a result, Europe's financial system has largely stabilized. Similarly, the Euro has passed its first major test and has stabilized below its peak but around levels that were seen during times of economic stability. It is also very likely that Europe’s huge fiscal programs will have a positive impact on the dire growth prospects for 2009.

Figure 2 Euro Exchange Rate

Figure 2 Euro Exchange Rate

Source: CEIC Database.
Note: The Effective Exchange Rate of the Euro Area is indexed at 1Q 1999 = 100.

The longer-term prospects look less promising than before the crisis, however. Much of Europe's growth had come from economic integration. But now economic policy seems on the way to further deepening regional imbalances within the EU. Instead of emerging strengthened from the current crisis, the existing gaps and omissions of EU integration will likely become even more visible when the dust has settled.